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FRM Part II · FRM Exam Part II · Empirical Properties of Correlation: How Do Correlations Behave in the Real World?

A bank risk team compares two portfolios of corporate credit exposures. Analysts observe that average default correlation estimated from a benign period is 0.03, yet during a recession the realized joint default frequency is far above what that correlation implies. Which interpretation best fits empirical evidence on credit correlations?

Default correlations tend to rise in recessions because firms share common macroeconomic drivers, so an estimate from a benign period understates joint defaults. Treating correlations as stable or independent given ratings ignores this cyclical, clustered behavior and leads to underestimated portfolio credit risk.

  1. ADefault correlations are stable through the cycle, so the recession result is a sampling error
  2. BDefault correlations are negatively related to the business cycle, so they should have fallen in the recession
  3. CDefault correlations tend to rise in recessions as firms share macroeconomic drivers, so a benign-period estimate understates joint default riskCorrect
  4. DDefault correlations are irrelevant because defaults are independent given ratings

Explanation

Empirical evidence indicates default correlations and default rates are higher in downturns because firms are exposed to common economic factors. Using a calm-period estimate therefore understates joint default probability. Stability and independence assumptions are contradicted by the evidence.

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